Cost of Money

Cheap cost of money is one reason why markets may discount negative news and continue to rise despite any short-term negativity.
I was invited to present at the Market Technicians Association, Global Intermarket conference at Budapest. Technicians from Central and Eastern Europe had come together to discuss the global Intermarket situation and outlook for 2011. In this first issue of the year, I will discuss the observations made at the conference regarding the larger global perspective and next week I will summarize the global outlook for 2011.
One of the key questions being raised at the conference was how the market was discounting everything from toxic paper, bad debt to all negative news and continuing its rally up? A significant answer raised by the panel was regarding the cost of money. If the cost of money was kept low, the equity market could discount more negativity and keep up the positive surprise.
Interest rates are an important indicator to watch for signaling the change of the cost of money. Though near zero interest rates are good for markets they are not sustainable. The Federal Reserve has so far been able to manage the yield curve on the short end. How far it can it do it in future is doubtful.
There’s another catch here. History may be important, but we don’t have a long market history. What we have seen is a long history of interest rates of nearly 2000 years. This is why just looking back trying to learn from the great depression might be shortsighted. We have talked about this prior, how deflation and inflation are known to have alternating cycles.
But then we have so many distractions linked with cheap money. According to Rona Schehrer from Schehrer Portfolio Management, Switzerland, “Near zero cost of money has been offering some support to the residential and commercial real estate market. Interest rate control is an illusion and not a solution. Near zero cost of money blows bubbles in different asset classes and is not the monetary tool to solve the long-term unemployment and economic problems. It is actually part of the problem, as capital savings are diverted to speculation. Printing a large amount of dollars has the opposite effect of debasing a stable monetary system.”
If you look at the US Libor 1 Year time series, you can see an emerging case of a bond market moving towards secular exhaustion. Bonds are a leading indicator compared to the USD Libor short-term rates. We need to wait until a topping blow off phase is more visible in global bond prices. It may have just begun. Moreover, it’s late for the secular bond uptrend, which has been continuing for more than 15 years. Sooner or later a cyclical shift could emerge. TBT, the 20 Year short Treasury bond ETF is one available instrument that lets you trade and hedge against a secular fall in yields.
The inflection whenever it arrives could affect all asset, classes. For a change, it could make it worthwhile holding the dollar for a little while. Only commodities provide the real value against a debased monetary system. Above this, we have the fear and panic linked to the instability in the current monetary system. Gold adjusts well to the cost of money owing to its low cost of carrying. Unless the printing press slows down investors will attempt to solve their problem through using metals as the store of value.
According to Rona “If the cost of money is kept low, we are in a process of creating fast and sequential bubbles. This would make bull markets fast and bear markets faster. We witnessed bubbles which shifted from blue chip investments into the dot.com. After the dot.com bust the public purchased and leveraged on housing. Cheap money pushes investors into poor decision making encouraging them into inter-market speculation. When the debt bubble bursts money may come out of bonds into other asset classes. Debt will begin to underperform other assets like commodities. The US municipal bond market is America’s Ireland, Greece, Spain and Portugal all put together. The AAA ratings do not reflect the debt risk.”
In the end, even if the stock markets may rise for another few years after any multi-month correction, investors should understand they have an extended risk and return profile and that real consistent gains of tomorrow will not come from the focus on returns, but from a focus on risk containment. Cheap money after all is a risk.